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Auteur

Bahaji, Hamza

Type

Communication / Conférence

Nombre de pages du document

499-508

Résumé en anglais

This paper examines the incentives from stock options for loss-averse employees subject to probability weighting. Employing the
certainty equivalence principle, I built on insights from Cumulative Prospect Theory (CPT) to derive a continuous time model to value
options from the perspective of a representative employee. Consistent with a growing body of empirical and experimental studies, the model
predicts that the employee may overestimate the value of his options in-excess of their risk-neutral value. This is nevertheless in stark
contrast with a common finding of standard models based on the Expected Utility Theory (EUT) framework that options value to a riskaverse
undiversified employee is strictly lower than the value to risk-neutral outside investors. In particular, I proved that loss aversion and
probability weighting have countervailing effects on the option subjective value. In addition, for typical setting of preferences parameters
around the experimental estimates, and assuming the company is allowed to adjust existing compensation when making new stock option
grants, the model predicts that incentives are maximized for strike prices set around the stock price at inception. This finding is consistent
with companies’ actual compensation practices that standard EUT-based models have difficulties accommodating their existence.